Tuesday, September 29, 2015

Rational Expectations and the Microfoundations of Autonomy

One aspect of modern economies that deserves more attention is the variety of beliefs that inform the decision making of households, firms, and governments.  Every asset market includes bulls who believe prices will rise and bears who believe they will fall.  Central banks and national governments draw on diverse macroeconomic models in their policy making, which is evident in the conflicting predictions about the effects of quantitative easing.  And Nobel Prizes in economics have been awarded to economists advancing sharply divergent theories, the most recent example being the 2013 Prizes awarded to Eugene Fama and Robert Shiller.

On its face this multiplicity of views seems incompatible with the hypothesis of rational expectations.  If all agents have access to the same information and the same (correct) model of the economy, then, instead of a multiplicity of expectations, we would see a uniformity of expectations.  Some of this real-world diversity of expectations can, of course, be explained by “information partitions” in which market participants have access to different pieces of the “information pie.”  The force of this explanation is diminished, however, by the broad dissemination of government statistics and the widespread use of information technology to organize and analyze this data.  Moreover, economists with access to the same data and information processing capabilities nevertheless produce conflicting explanations of historical trends and events, divergent forecasts of future trends, and opposing predictions about the effects of various monetary and fiscal policies.

This multiplicity of outlooks, whether in the form of theories, models, beliefs, or expectations, calls into question the usefulness of the postulate that economies are always in equilibrium.  Even if a rational expectations, representative agent, model could be calibrated to track some time series of economic data, it could hardly explain the obvious presence of agents with diverse and, often conflicting, views.  Furthermore, if market participants are acting on the basis of inconsistent expectations, then at least some of these expectations will disappointed and some plans will have to be revised.  To insist on characterizing an economy in which the participants are planning to buy and sell at different prices as being in equilibrium is simply to insist on a stipulated definition come what may. 

In their Anti-Keynesian manifesto, Lucas and Sargent (1979) criticize the lack of microfoundations in the Keynesian models that were developed in the 1950s, 60s, and early 70s.  Many reasons have been offered in defense of microfoundations as a necessary feature of a good macro model, including an implicit appeal to the familiar notion of autonomous agents who form and act upon their own plans and forecasts.  Thus, Lucas and Sargent chastise “economists who ten years ago championed Keynesian fiscal policy as an alternative to inefficient direct controls [now] increasingly favor the latter as ‘supplements’ to Keynesian policy” (original stress).  But it’s the gloss they add to their argument that’s most revealing.  Mocking these old fashioned Keynesians they write, “The idea seems to be that if people refuse to obey the equations we have fit to their past behavior, we can pass laws to make them do so” (original stress).  Free and independent agents keep changing their minds in response to new information, so their “past behavior” is, at best, an imperfect guide to their future behavior.

A closer look reveals that the New Classical demand for microfoundations straddles two incompatible ideas.  On the one hand, Lucas and Sargent insist on microfoundations because they believe economic outcomes depend on the rational choices of individuals rather than on the behavior of aggregates.  What is “the Lucas critique” if not a vigorous statement of this point?  On the other hand, genuinely autonomous agents, who choose their own objectives and the means of achieving them, will often hold different views about the future.  Indeed, this a reasonably good description of what happens in societies when the unquestioned guideposts of custom and tradition give way to some measure of individualism and self-determination.  Thus, while the demand for microfoundations appeals to the idea of independent agents constructing their own action-guiding scenarios, the variety of beliefs that emerge from, and guide the actions of, these agents is suppressed by the premise of rational expectations.  If we really want macroeconomic models that are consistent with free and independent agency, then we need a new “microfoundations of autonomy.”  I’ll return to this topic in a future post.

Wednesday, August 5, 2015

In Defense of Robert Solow’s “Sarcasm”

Paul Krugman writes, “Paul Romer continues his discussion of the wrong turn of freshwater economics, responding in part to my own entry, and makes a surprising suggestion — that Lucas and his followers were driven into their adversarial style by Robert Solow’s sarcasm.”

No examples of Solow’s sarcasm are given by Krugman or Romer, but perhaps the following qualifies in their view:

“Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon. Now, Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then you have tacitly gone along with their fundamental assumptions; your attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.”

This isn’t sarcasm.  It’s a refusal to enter into a discussion with economists who refuse to discuss their own fundamental assumptions, viz. the “classical postulates” of rational choice and market clearing.  The analogy that comes to my mind are the libertarian arguments of Robert Nozick.  If you’re drawn into a debate over whether certain policies violate someone’s property rights, you’re apt to forget that it’s Nozick’s conception of property rights, itself, which is in need of justification.

Solow isn’t the only first-class economist who has found New Classical economics not worth delving into.  Although Lucas looks to the Arrow-Debreu model and its date- and state-dependent commodities as pillars supporting his own modeling, Arrow, himself, has rejected the notion that the macroeconomy is always in equilibrium and has mocked New Classical explanations of the Great Depression.  And Frank Hahn, who wrote an important book with Arrow, regarded modern general equilibrium theory, not as a framework for modeling the macroeconomy, but as a “list” of the far-fetched conditions required to rule out “Keynesian problems.”

I find New Classical Economics very clever and kind of interesting, but the scientism and “methodological arrogance” exhibited by some of its proponents is repellent to me.

Thursday, July 9, 2015

The Economics of George Orwell, Not

   Roger Farmer has a couple of provocative    
   posts on behavioral economics.  The first   
   is entitled "The Economics of George 
   Orwell," where Farmer offers two 
   criticisms of behavioral economists such 
   as Richard Thaler, George Akerlof, and 
   Robert Shiller:

1. “Behavioural economists assert that what makes individuals truly happy can be different from what they in fact choose to do. In Akerlof and Shiller’s words, ‘...capitalism...does not automatically produce what people really need; it produces what they think they need...’ (p. 26).”  From these assumptions, it’s pretty easy to draw paternalistic conclusions, which lead, not to happier people, but towards Orwell’s 1984 dis-utopia; and

2. Neoclassical economics doesn’t need behavioral psychology. Instead Farmer insists, “we can understand all of the failures of classical macroeconomics without giving up on rational choice.”

Leaving Farmer’s second proposition for a future post, I do want to say something about “classical liberalism,” an outlook affirmed by Farmer and well-expressed in his critical reaction to the very idea that someone could know a person’s “true preferences” better than the person, himself, does.  

Consider one of the most effective “nudges” emerging from behavioral economics – changing the default option for employee contributions to a deferred income account from zero to, say, 5%.  In other words, instead of requiring employees to “take action” in order to defer income, they now have to “take action” to avoid deferring income.  Does this change in the default option assume that policymakers know more about employee preferences than the employees themselves do?

Not necessarily.  Suppose there’s lots of research showing that a great many middle-age workers either haven’t done any retirement planning or have wildly optimistic forecasts of their income in retirement.  By “wildly optimistic,” I mean forecasts that would be rejected by, say, 95% of certified financial planners.  So, in this case, the policymakers aren’t substituting their (assumed) preferences for “less current income and more future income,” rather they are assuming that if employees had reasonable forecasts of their own retirement income, many of them would choose to defer some their current income.

Farmer says, “The idea that the government knows my preference better than I do is a little too Orwellian for me.”  I think it’s worth distinguishing between “ill-informed” and “well-informed” preferences.  Granted, this distinction can become a pretext for paternalism.  But, in the case at hand, no one is compelling employees to save more.  Requiring employees to “check a box” to opt out of a deferred income plan doesn’t really qualify as “Orwellian,” particularly when some sort of default option is required in any case. 

The fact that a significant number of employees began to defer some of their income when deferral became the default option raises another, deeper question about Farmer’s classical liberalism, namely how do our preferences arise, persist, and change over time?  Can anyone really believe that capitalism always produces “what people really need”?  Farmer’s models include profit-maximizing firms.  Are we to assume that producing “what people really need” is always more profitable than creating new “needs”?  Should we assume that the $180 billion U.S. firms spent on advertising in 2012 merely conveys information to the public?

It’s not just advertising that shapes our preferences, but rather the whole culture.  Farmer seems to think that we freely choose our preferences, and he worries that if “the form of the utility function is influenced by 'persuasion', then we lose the intellectual foundation for much of welfare economics.”  Insofar as this “intellectual foundation” includes the conception of “preference” Farmer seems to have in mind, it has already been subjected to withering criticism by Amartya K. Sen and others (see especially Sen’s well-known papers, "Rational Fools" and "Behavior and the Concept of Preference").

Saturday, January 24, 2015

Is Continuous Market Clearing a Good Premise for Macroeconomic Modeling?

I haven’t quite finished Kartik Atherya’s book, Big Ideas in Macroeconomics, but one proposition, in particular, seems implausible to me, and that’s Kartik’s claim that real world markets are very similar to a "Walrasian central clearinghouse."  In short, real world markets operate as if they were run by an auctioneer who's continuously finding the prices at which supply and demand are equal.

Just for the fun of it, I decided to explore the prices at which Big Ideas in Macroeconomics was being offered on Amazon.com.  All the prices I recorded were for a new copy of the book and include the cost of standard shipping.  The chart below displays the offer price for Big Ideas and the "percent favorable ratings" for 23 sellers.  I’ve excluded one Amazon Prime offer because Amazon Prime membership costs $72, and provides free two-day shipping among other benefits.

Here are a few statistics from this single day on Amazon: 1) the mean price of Big Ideas was $49.65; 2) the lowest price was $23.99; 3) the highest price was $75.81; and 4) the standard deviation was $14.07.  (The Amazon Prime price with free two-day delivery was $35.11, but isn’t included in the chart). 

My question is: if this online market is like a Walrasian clearinghouse, how can we explain the wide dispersion of prices for this standardized item?  One possibility is that suppliers with good reputations (high favorability ratings) might be able to charge a higher price because buyers have more confidence that the book will be delivered on time.  As it turns out, the opposite is the case: lower prices are correlated with higher ratings.  

This pattern of prices is not what one would expect if Amazon.com actually resembled a Walrasian central clearinghouse.  Now it might be objected that the “higher” prices don’t really “count” because few transactions will take place at these prices.  Perhaps, but if so, why do "high-price" dealers bother to post a price at all?  Since anyone can find out what prices are being offered on Amazon, why would a bookseller who saw ten offers at $50 or less decide to offer the same book for, say, $65?

I’m open to other explanations, but my tentative conjecture is that Amazon.com, which typically has a wide range of prices for identical items, doesn’t look like a Walrasian market at all.  And if Amazon.com doesn’t fit the bill given all of its apparent market-like virtues, then how many other markets depart from the ideal?